The Term Structure of Funding Spreads

40 Pages Posted: 11 Feb 2009

See all articles by Joachim Inkmann

Joachim Inkmann

University of Melbourne - Department of Finance; Financial Research Network (FIRN)

David P. Blake

City University London - Cass Business School

Date Written: July 2008

Abstract

Defined benefit pension liabilities are usually computed by discounting promised future pension payments using the yields on either risk-free or AA-rated bonds. We argue that a pension plan in financial distress should use discount rates that reflect the inherent funding risk. We propose a new valuation approach that utilizes the term structure of funding-risk-adjusted discount rates. These discount rates depend on the current asset allocation of the pension plan which affects expected future funding ratios. We show that an optimal asset allocation which accounts for this dependency varies in a highly nonlinear way with the initial funding ratio of the pension plan. In particular, the optimal allocation to stocks is higher than conventionally determined when the level of underfunding is severe, but lower when the level of underfunding is only moderate

Keywords: term structure, funding risk, funding spread, asset-liability management

Suggested Citation

Inkmann, Joachim and Blake, David P., The Term Structure of Funding Spreads (July 2008). Available at SSRN: https://ssrn.com/abstract=1340360 or http://dx.doi.org/10.2139/ssrn.1340360

Joachim Inkmann

University of Melbourne - Department of Finance ( email )

Level 12, 198 Berkeley Street
University of Melbourne, Victoria 3010
Australia
0061 3 9035 8177 (Phone)

HOME PAGE: http://orcid.org/0000-0002-5526-7648

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

David P. Blake (Contact Author)

City University London - Cass Business School ( email )

London, EC2Y 8HB
Great Britain
+44 (0) 20-7040-5143 (Phone)
+44 (0) 20-7040-8881 (Fax)

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